Archive for March, 2010

Against a still struggling recovery, and continuing weakness in state revenues, talk in Washington is turning to cutting back. That may sound strange, but hear us out.

With the Obama administration released its proposed 2011 budget last month, a lot of attention has rightly been paid to the ginormous deficit—its possible corrosive economic effects and the possible difficulties in funding it. But what’s lost in those worries is what’s going to happen as the stimulus program expires.

Specifically, after the most fiscally stimulative budgets in modern history, barring major changes, policy is about to turn much tighter.

Structure of the Deficit

The federal deficit can be thought of as having two major components, structural and cyclical. The structural deficit is what the balance would be were the economy at full employment; the cyclical component is the contribution that comes from departures from full employment, i.e., the state of the business cycle.

The graph below shows changes in the structure of the deficit from 2007 through 2018. Sometimes the cyclical component is positive, lessening the deficit (as was the case in 2007); sometimes it’s negative, as it is most other years:

(These estimates come from the Office of Management and Budget, as part of the President’s budget for 2011. Despite that authorship, the estimates look cautious to us. They define full employment as an unemployment rate of 5.5%, and we don’t see the economy returning to that level until 2017. And even if they’re optimistic on magnitudes and the longer-term trend, they’re probably not wrong about the direction of things over the next couple of years.)

The best way to isolate the policy effects of changes in government spending is to look at the cyclically adjusted balance. If the deficit passively swells because of recession, that’s just the so-called automatic stabilizers switching on. But if policy adds to it, through spending increases or tax cuts, then it becomes actively stimulative.

The table below shows OMB’s estimate of the total budget deficit through 2018, and we are concentrating on the next few years. In fiscal 2010, the total budget deficit is 10.5% of GDP, 3.2% of it the result of the recession and 7.3% of it structural, or from policy. That’s up from a deficit of 9.9% of GDP in 2009, 2.4% of it cyclical and 7.6% of it from policy. In other words, while the 2010 deficit is larger than 2009’s, the main reason for that is cyclical, not structural, since there’s less stimulus and bailout spending coming this year than last. Going forward, the structural deficit is projected to continue shrinking—to 5.1% of GDP in 2012, and 3.0% the following year.

The Fiscal Impulse

Changes in the structural budget balance are sometimes called the fiscal impulse, shown in the right column. The decline in the structural deficit from 7.3% of GDP in 2010 to 5.1% in 2011 results in a contractionary fiscal impulse of 2.2% of GDP. Both the OMB and the CBO try to separate the cyclical and policy contributions to the deficit. The CBO’s number start in 1962 and end in 2011, and the OMB’s run from 2007 to 2017. If we splice the OMB and CBO series together, which is only slightly reckless since they’re pretty similar when they overlap, this is one of the starkest episodes of fiscal tightening in the last five decades, exceeded only by the 3.1% shift in 1969. A recession began in December 1969 and continued through November 1970. The second-biggest tightening was in 1987, the year of the stock market crash, which was followed a little later by a long period of sluggishness.

Of course, the fiscal impulse can be stimulative. By the CBO’s measure, the 2009 impulse was expansive to the tune of 5.9% of GDP; by the OMB’s, it was 4.5%. These numbers are three or four times earlier maximums, like those of 1983 or 2002. And it’s not unreasonable to conclude that what economic recovery we’ve seen since mid-2009 is the result of this massive stimulus. This is apparent not only at the abstract macro level of budget numbers—it’s visible in specific cases, like the effect of cash-for-clunkers on car sales (which ebbed when the program expired) and the effect of federal support on the housing market (there would simply be no mortgage market without Washington’s support). So what is going to happen as the Fed’s purchase of mortgage securities ends in March? As the stimulus spending declines to a trickle

According to a simple regression, the fiscal impulse has an almost one-for-one influence on GDP growth. (See graph below.) So next year’s drag of 2.3% of GDP implies a brake on growth almost that large. Of course, fiscal policy, while important, is far from the only influence on growth; the regression’s r2 is .10, suggesting that it explains about 10% of the yearly variation in GDP growth (though from eyeballing the graph, we see that the extreme cases seem to matter most). That’s not beanbag, but it still leaves a lot to be explained.

A stronger influence on growth is the change in nonfederal credit; as shown in the graph below, it explains about 18% of the yearly variation in GDP growth. Together, the two explain close to 30% of the yearly variation in GDP growth. Putting the two together suggests that we’d need a very strong growth rate of 7-10% in nonfederal credit this year and next to offset the fiscal drag. We’ve only come close to that in two years out of the last 50. So we’re back to a dilemma we’ve identified many times: it looks like GDP growth needs a major revival of private credit expansion—but is that possible or even desirable?

Given that 70% of GDP growth remains unexplained by these two variables, we don’t mean them as literal projections. But it does offer support for fears that since the recovery was driven by fiscal stimulus, once that’s gone, we could be in trouble again.